Why These 3 Issues Could Derail KB Homes

KB Homes (NYSE: KBH) shares have grown 50% over the past 18 months. But at its current highs, the stock might have little upside left, thanks to three looming concerns.

Where do we go from here?

KB Homes is the 10th largest publicly traded homebuilder by market capitalization, and, as of recent, shares have put together their highest prices since 2008. To keep shares rising, KB Homes needs to continue expanding its business -- but some of its plans to do so seem uncomfortably risky.

The company is one of the leaders in West Coast home construction, which accounts for around 50% of its overall revenue. The company has about 10% of its business in the Inland Empire region of California, where it expects to build five new communities over the next 12 months, in addition to about a dozen developments it already has there. In 2012, KB had about 190 total communities nationwide, so this area does represent a fairly big chunk of the company's overall efforts.

KB believes the region is experiencing a surge in demand for homes. But according to statistics, the Inland Empire ranked fourth nationwide in 2010 in terms of foreclosure numbers. It also has much lower average selling prices than the rest of California, making it a higher-risk market.

Furthermore, the latest data shows California's unemployment rate at 8.9%. In the Inland Empire region, which encompasses the Riverside, San Bernardino, and Ontario metropolitan areas, that number climbs to 10.4% .

KB might have better luck expanding into regions like the Southwest, which provided just 10% of its net orders in the latest quarter. With an overall unemployment rate of 6.4% , a state like Texas might give KB a better chance to expand its operations and diversify its revenue.

KB Homes claims that California has growing jobs and low housing inventory, but the latest data only partially supports that idea . California areas like San Francisco and San Diego do have low inventories of homes for sale at 3,094 and 8,637, respectively. That creates strong pricing for homes there -- an average of $450,000 in San Diego and $800,000 in San Francisco.

But KB's also operating in other, less promising markets like Riverside and Los Angeles, where the average home is valued at $250,000, and 26,000 homes remain available. Further, Los Angeles has nearly 30,000 homes in inventory, with an average home priced at $445,000. KB's expecting these areas to help it grow in the future, but these numbers suggest it may not get what it's hoping for.

It's risky enough for KB to depend so heavily on just one state , but the company's current valuations make it an even more uncertain investment. With a 77 P/E and a price-to-book ratio greater than 3, the company has priced in a lot of its future growth at this point. The industry average for P/E and price-to-book in residential construction is 27.8 and 2.3, respectively. That comparison shows that KB Homes sits at quite a rich valuation compared to its competition, and may have priced in a lot of future growth already.

What happens when interest rates rise again?Interest rates have been at rock-bottom levels for years, but rising rates could hurt the company even more in California. Over the long term, interest rates will naturally rise as unemployment falls. But if rates spike over the next six to 12 months, they could squeeze would-be buyers out of a California market that already boasts strong pricing.

Moreover, even at 4.75%, interest rates are still very low by historical standards. But the speed at which rates climb matters in the short-run, Mr. Duncan says, because it can force would-be buyers to adjust what they're willing to pay.

Consider: a homeowner shopping for a $500,000 house and making a 20% down payment would have been able to purchase a home in April with a 3.5% rate that offered a $1,800 monthly payment. Right now with a 4.75% mortgage rate, the same house would cost 16% more on a monthly payment basis, or almost $300 more.

With demand for housing rising, interest rates are likely to at least stay at their current levels, if not rise further, which could put pressure on some of the high-end homes that KB has -- and those homes' potential buyers.

It's not all badKB may have a lot of business in California, but it does realize the potential in financial services, as well as the Southwest. Thankfully, it's trying to diversify its revenue stream by offering financing in partnership with lender Nationstar Mortgage .

KB's revenue from financial services accounted for $5 million in the last six months, or 0.5% of total revenue for that period. That may be insignificant to the bottom line, but expenses eat up just 30% of its financial services revenue -- compared to 99% of homebuilding revenue. Right now, this isn't doing much to help KB grow. But successfully expanding its partnership with Nationstar might help the company boost its overall margins and revenue in the future.

Additionally, Nationstar is Texas-based. Remember how we mentioned the state's relatively low unemployment rate? The move with Nationstar suggests that we should see more Texas opportunities in the future, and the company has signaled it's an important market for growth moving forward . If they can adopt more business in this area (and depend less on the West Coast for business), KB Homes could begin to fill the shoes of its hefty valuations.

TakeawayDuring times like these, when the housing market is very healthy, it's hard not to get overly excited about all of these stocks. But for now, we need to see more from KB Homes in order to get behind them. The company needs to broaden its revenue sources, and prove that it has a plan to deal with potential interest rate hikes. In addition, the valuation just looks too high, given the company's limited growth potential. Before you make any decision on KB Homes, keep a close eye on interest rates, and monitor how well KB does in new markets like Texas.

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I believe there is also a 4th issue that could derail the company, which is all of the angry KB Homeowners, news story after news story and several websites currently against the company such as http://www.kb-homesucks.com